Do You Need More Foreign Content?
Ways to boost foreign exposure
Have you ever heard of something called the "Efficient Frontier"? If you haven't, take a look at the marketing material for just about any foreign equity fund and you'll find this concept used to promote the benefits of investing outside of our domestic borders. This week we'll examine the real meaning of the efficient frontier, whether or not you actually need more foreign content, and the most efficient ways to get your desired exposure.
The efficient frontier is a theoretical concept that basically looks into the past to determine the optimal mix of domestic and foreign stocks that would have paid off best during some past time period. The result is a curved line graph representing various portfolio mixes that would have delivered an optimal combination of risk and return during the time period studied. There are a couple of key problems with this concept.
The problem that will be obvious to many of you is the fact that this concept is based on historical risk and return data. If you've seen at least one mutual fund advertisement, you know that "past performance is no indication of the future". This is especially true when the time period studied is just ten or fifteen years.
The other major problem lies in the inability to clearly quantify risk. The fact is that risk means different things to different investors. Most commonly, risk is defined as a decrease in investment value. In the efficient frontier model, a statistical measure known as standard deviation is used to measure risk. The problem is that standard deviation counts both upward and downward movements as "risky". There are other shortcomings that are more technical in nature, but you get the idea.
Determining your foreign exposure
Obviously I can't tell each of you how much foreign exposure you need but I hope to give you a bit of guidance in making that decision for yourself. Let's look at the example of a typical Canadian investor. If we assume return targets and risk tolerance are about average, it's likely this investor would get a recommendation for a balanced portfolio - about 60 per cent in stocks and 40 per cent in bonds and cash. A good rule of thumb for such investors is to place half of the stock holdings in foreign markets. That puts exposure to US and overseas stocks at 30 per cent of the total portfolio. That just happens to be the RRSP foreign content limit as of this year. Obviously, more aggressive return targets would call for more stock exposure and even more outside of Canadian borders.
However, most Canadians can't get enough foreign exposure and are paying higher fees to skirt foreign content limits. This is potentially damaging due to higher costs. Worse, investors may be overlooking more efficient ways to boost foreign exposure.
Ways of boosting foreign exposure
In order of preference, here are some tips on boosting foreign exposure.
RRSP eligible index funds are a great option but they are only suitable for tax-deferred accounts like RRSPs. I've said before that indexing is the way to go in the US, so a RRSP eligible US index fund is a great way to get US stock exposure. Why? These funds use fancy things called index futures contracts (a type of derivative). The bottom line: you get full exposure to a stock index - like the S&P 500 - but transaction fees are razor thin compared to a regular index fund that holds stocks. Good picks in this category are Altamira Precision RSP US Index and Greenline US RSP Index. Also, keep an eye out early in the second quarter for a similar offering from Barclays in the form of an exchange-traded fund. I would expect fees to be substantially less than the available funds but that's not yet final. For overseas stocks, I still prefer actively managed funds with relatively low turnover (i.e. trading frequency), reasonable fees, and a solid management team, like AGF International Stock and Templeton International Stock.
Non-RRSP accounts shouldn't be ignored as a source of foreign exposure. On specific cases I've reviewed, I've recommended many times that clients keep their non-RRSP portfolio heavier into foreign holdings to offset their RRSP, which are heavy into domestic holdings.
Foreign-heavy Canadian funds are one of the most straightforward ways to gain additional foreign exposure. Recall that a fund is considered 100 per cent Canadian content as long as it has at least 70 per cent of its assets (based on book value - i.e. original cost) in Canadian securities. In essence, by holding your 70 per cent in a fund that, itself, maximizes foreign content, then holding your allowable 30 per cent in a foreign content holding, you've automatically boosted your total foreign exposure to 51 per cent ( [0.7 x 0.3] + 0.3 ).
There are two caveats with this strategy. The funds that best fit your strategy may not have a policy of maximizing foreign content. That's fine because the overriding factor in your choice of funds should be that they first fit into your plan, with tax and foreign content issues becoming secondary. Also, managers good at picking Canadian stocks may not do so well at picking foreign stocks, so check out the same firm's foreign stock funds in assessing the team's skill. Trimark and Fidelity are two firms that are great at picking both Canadian and foreign stocks, making a good fit for this strategy.
Clone funds have appeal because it allows investors to get their favourite actively managed funds (like Templeton Growth) in a RRSP eligible package. The structure is a bit more complex than the RRSP eligible index funds and that results in additional embedded costs not reflected in the MER. For example, that means Templeton Growth RSP will underperform the regular Templeton Growth fund by about 0.50 per cent annually over time. Due to the added costs, this should be the last resort for boosting foreign exposure. Again, these should only be held in a tax-deferred account.
Holding labour sponsored investment funds (LSIF) in your RRSP allows you to boost foreign content by up to $3 for each $1 invested in a LSIF. LSIFs have big return potential and big risk, so no more than 5 to 7 per cent of the total portfolio should be in such funds. Again, I can't stress enough that these funds should not be bought just for the tax benefits. Buy them on investment merit to the extent they fit into your strategy. Covington, Vengrowth, First Ontario, Working Opportunity (BC), ENSIS (MB), and Working Ventures are worth a look. I'm still finishing my research on these funds so my opinion isn't yet finalized, but I like what I see in these funds so far.
Don't assume you need more foreign content until you've reviewed your objectives and you've found fundamental reasons to weight foreign stocks more heavily - such as the need to generate high returns. As for foreign bonds, it's not an area I'm bullish on at the moment given our already beaten up currency and relatively strong economy. And if you do decide you need more foreign exposure, review my tips above to make sure you do it in a smart and efficient fashion.
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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